It's fairly obvious that Russia’s industrial production is dependent on state spending, but recent spending cuts made by the finance ministry as it desperately tries to balance the budget, highlight just how closely the two are intertwined.
As opposed to retail turnover with its continued contraction, both industrial production and construction reacted to an acceleration in budget spending over the first part of this year and year-on-year industrial production even went back into the black in June.
Then after July’s 0.3% y/y decline, industrial output grew again by 0.7% y/y in August, while construction posted a modest 2.0% y/y decline last month as opposed to 3.5% y/y decline in July.
These improvements in construction and industrial production came together with a huge rise in state spending from RUB693bn ($10.9bn) to a peak of RUB8.5 trillion ($133bn) in August.
It is not clear what the state was spending all this money on, especially as the government since the start of the year reined in military spending as it turns its attention from defeating US interests in Ukraine and Syria to other areas. For example, paying pensions became a more prominent issue before September's parliamentary elections. Alfa Bank speculated in a recent note that more money is now being invested to spur economic growth.
“We consider that production growth/investment activity could reflect acceleration in budget expenditures growth: in August the cabinet spent RUB390bn from the Reserve Fund to cover acceleration in expenditures growth, while in June-July the budget was virtually balanced,” Natalia Orlova, chief economist with Alfa Bank wrote.
However, the state spending was cut dramatically in August during the holiday season and it is not clear how vigorously the spending will resume after the start of the school year on September 1. This generally marks the start of the high season in Russia and the following four months are where the majority of the work gets done, suggesting spending will bounce back.
Industrial production is heavily dependent on state spending, but of course other factors weight on companies’ earnings as well. The decision by the Central Bank of Russia (CBR) to cut overnight rates to 10% was welcome, but the accompanying statement saying this was the last cut of the year was not.
The market had been anticipating more cuts of 100-150bp in total in the last part of the year after inflation fell below 7% for the first time since 1991. But the regulator said it is still concerned about potential inflation and is pulling out the stops to ensure it hits its 4% target — a goal the economy ministry says in its latest outlook will only be achieved in 2019. The result was the real economy had a mild shock as higher borrowing costs are now fixed for the rest of the year, when it was expecting them to fall further.
“While we share completely the tight stance of the CBR policy, we consider that the open commitment for the flat nominal rate came as a very negative surprise for the real sector, which was pricing a continuing monetary easing,” Orlova said. “Given the CBR recent guidance and the relatively tight budget policy we have to cut our -0.3% y/y GDP forecast to -0.8% y/y for FY 2016.”